Leveraged Trading: A professional approach to trading FX, stocks on margin, CFDs, spread bets and futures for all traders

Contents

About the Author

Preface

Who should read this book?

How does this book differ from my first book, Systematic Trading?

What’s coming

Introduction

The mistakes that losing traders make

Why leverage is dangerous

Why you should use a system when you start trading

How is this book different from other trading books?

Part One: Fundamentals

Chapter One: Types of Leveraged Trading Product

Introduction to leveraged trading

Three key characteristics of leveraged products

What products are there for leveraged trading, and how do they work?

Products and underlying instrument are different

Chapter Two: Getting Ready to Start Trading

1. Choosing your trading software, hardware and data feed

2. Choosing which product to trade

3. Choosing your broker

How much money do you need?

Chapter Three: Introduction to Trading Systems

Why you should use a trading system

Common arguments against using trading systems

What makes a good trading system?

Why you should avoid third party trading systems

Part Two: Starting to Trade

Chapter Four: Concepts

Some definitions

Risk and return concepts

Minimum trades and minimum capital

Costs

Chapter Five: Introducing the Starter System

An overview of the system

Which instrument and product to trade?

When should we open positions?

How large should positions be?

When should positions be closed?

Chapter Six: Trading the Starter System

Before you start trading

Tasks on day one

Tasks on subsequent days

Trading diary

Summary

Part Three: Diversifying

Chapter Seven: Adding New Markets

Advantages and disadvantages of diversification

The theory of diversification

Trading the Starter System adapted for multiple instruments

Chapter Eight: Adding New Trading Rules

The case for diversification of trading rules

My suite of trading rules

How do we use multiple trading rules?

Using multiple trading rules in practice

Part Four: Advanced Trading

Chapter Nine: From Discrete to Continuous Trading

Why it can be safe to trade without a stop loss

Continuous trading

Practical trading without a stop loss

Chapter Ten: Position Adjustment

Adjusting position size for confidence: non-binary trading

Adjusting position size for risk

Adjusting position size without incurring heavy trading costs

Practical non-binary trading

Chapter Eleven: What Next?

1. Improvements to the Starter System

2. Back-testing and designing your own system

3. Semi-Automatic Trading

Epilogue

Glossary

Appendices

Appendix A: Useful Information

Further reading

Useful websites

Appendix B: Costs

Transaction costs

Holding costs

Total costs

Minimum capital and costs

Smarter execution to avoid the spread

Appendix C: Calculations

Back-adjusting prices

Instrument risk calculation

Moving average calculations

Breakout calculations

Performance ratio

Acknowledgements

Publishing details

Reviews of Systematic Trading by Robert Carver

A remarkable look inside systematic trading never seen before, spanning the range from small to institutional traders. Reading this will benefit all traders.

Perry Kaufman, author of Trading Systems and Methods

Rob goes into a level of depth which most trading book authors either deliberately avoid or simply lack knowledge of. Rob’s background in the industry is beyond reproach and the informational contents of his book shows his experience and depth of knowledge. If you want to enter the professional systematic trading field, Rob’s book is a must.

Andreas Clenow, CIO Acies Asset Management and author of Following The Trend

Being a hedge fund manager myself and having personally read almost all major investment and trading books, this is by far one of the best books I have read in over 15 years on a tough subject for most.

Josh Hawes, Hedge fund manager

Robert has had very valuable experience working for many years in a large quant hedge fund, which makes the book doubly worth reading.... Well worth a read for anyone who trades, in particular for systematic traders (whether you’re a novice or more experienced)!

Saeed Amen, FX trader and author of Trading Thalesians

Reviews of Smart Portfolios by Robert Carver

I’ve been a fan of Robert Carver’s work for quite a while now, and this book definitely adds to the knowledge and experiences he willingly shares with others. Carver skillfully mixes theory and practicality, making this a great reference guide for intermediate and very experienced traders alike. Highly recommended!

Kevin Davey, Champion full-time trader, author of Building Winning Algorithmic Trading Systems

In Finance (like many other subjects) there is a large amount of research that is smart but impractical and an equally large amount of popular literature that is practical but dumb. This book is in that rare category of smart and practical – it is also an entertaining read in its own right.

Francis Breedon, Professor of Finance, Queen Mary, University of London and former global head of currency research at Lehman Brothers

The book is a solid piece of work so check it out... It’s about the process and there are some really practical ways, mathematical ways, to put a good process in motion for your life.

Michael Covel, author of Trend Following

When you combine ignorance and leverage, you get some pretty interesting results.

Warren Buffett, legendary investor

… the best minds were destroyed by the oldest and most famously addictive drug in finance, leverage.

Carol Loomis, Fortune magazine 1998

Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 81% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how these products work and whether you can afford to take the high risk of losing your money.

Risk warning from a brokerage web page

About the Author

Robert Carver is an independent trader, investor and writer. He spent over a decade working in the City of London before retiring from the industry in 2013. Robert initially traded exotic derivative products for Barclays Investment Bank and then worked as a portfolio manager for AHL – one of the world’s largest hedge funds – before, during and after the global financial meltdown of 2008. He was responsible for the creation of AHL’s fundamental global macro strategy, and subsequently managed the fund’s multi-billion dollar fixed income portfolio.

Robert has Bachelors and Masters degrees in Economics, and is currently a visiting lecturer at Queen Mary, University of London. His first book Systematic Trading: A unique new method for designing trading and investing systems was published by Harriman House in 2015, and his second Smart Portfolios: A practical guide to building and maintaining intelligent investment portfolios came out in 2017. Robert trades his own portfolio using the methods you can find in his books.

Preface

Leverage (verb): use borrowed capital for an investment, expecting the profits made to be greater than the interest payable

Oxford Dictionary of English

Not so many years ago the use of leverage for trading was the exclusive domain of highly-trained investment professionals. Sharply dressed denizens of Wall Street or the City of London would happily borrow, and then gamble, hundreds of millions of dollars or pounds. But such risky behavior was not for the average Joe (or Jane).

Things have changed. With the right broker, and just a few hundred dollars or pounds, anyone can become a leveraged trader. In the US it is easy to buy stocks, or bet on them falling, with a margin account. UK traders can make spread bets or take out contracts for difference (CFDs) on their favorite shares, as easily as betting at the local racecourse. In both countries, and in many others, you can trade foreign exchange (FX) and futures.¹

Leverage has levelled the playing field for smaller investors, but it has also made trading riskier. Leverage is inherently dangerous. With too much leverage a modest trading loss can be magnified into a wealth-destroying explosion. Leverage also increases the costs of trading: doubling your leverage will double your trading costs. Traders who manage to avoid a quick death from blowing up will instead die slowly, with high costs gradually emptying their accounts.

Because leverage is so dangerous, it is absolutely vital to use a safe level of leverage when trading. Deciding on how much leverage to use is the single most important decision that any trader will have to make.

To protect yourself from the dangers of leverage it is my belief that you should use a system when you start trading. This comes from my own experience: I have traded leveraged financial products for an investment bank without a system, and for a multi-billion-dollar hedge fund² that traded exclusively with systems. Now I trade my own money using purely systematic methods.

Trading systems have a poor reputation, but a simple system is much less likely to lose money than an inexperienced trader. If you use a system when you start trading, it will significantly improve your odds of becoming a profitable trader. A good system will calculate the right amount of leverage, protecting you from the dangers of serious losses and high costs.

But finding a well-designed trading system is a daunting task. There are thousands of books and websites offering potential systems, many of which are badly designed and even potentially dangerous. Many system designers give scant attention to the importance of managing risk by controlling leverage.

Instead they rely on incorrectly calculated stop losses³ to limit losses (and indeed, as I explain later in the book, a stop loss is unnecessary in a properly-designed trading system). They are obsessed with finding the elusive perfectly accurate trading rule, when it is far more important to control risk and trading costs. They try and predict the price changes in a single market, but a good system designer knows that diversifying across many different markets is likely to be far more rewarding.

In this book, I introduce a properly-designed, but also simple, trading system. I then explain how to improve its expected performance: by trading additional markets, and also through adding new features. Not everyone will want to continue trading with a system. As you gain skill and knowledge you may wish to start using your own intuition to make decisions about buying and selling. I will explain how to combine human judgement with a trading system, so that you remain protected from the dangers of excessive leverage. This method, which I call Semi-Automatic Trading, is described in the final chapter.

Who should read this book?

This book is for traders who want to learn how to trade safely using leverage. It covers:⁴

foreign exchange trading (FX⁵ or Forex)

futures contracts

contracts for difference (CFDs) trading

spread betting

trading stocks with a margin account

No prior experience or knowledge is required, so this book is suitable for newcomers to trading. But even experienced traders should find the book useful, since I will be challenging many of the preconceptions that most people have about trading.

You do not need much money to start trading leveraged financial products – just a few hundred dollars or pounds. However, you should only trade with cash you can afford to sacrifice, as with any kind of leveraged trading there is always a possibility that you could lose everything.

The examples in this book are aimed primarily at readers from the US and UK. However, traders from other countries can also use the system I explain. Be aware that local regulations may ban or limit the use of certain leveraged products. Tax laws will also be different from country to country.

How does this book differ from my first book, Systematic Trading?

If you read the ‘About the author’ section, you will see that I wrote another trading book a few years ago: Systematic Trading (ST). Perhaps you are browsing online or in your local bookshop and trying to decide which of these two books you should buy. Maybe you already own ST, and are considering adding this book, Leveraged Trading (LT), to your collection.

To help you decide, the main differences between the two books are:

As the title suggests, ST is mostly aimed at traders who are enthusiastic about systems trading. LT helps new traders learn how to trade by using a system, but then explains how to combine the system with their own human intuition; the method I’ve named ‘Semi-Automatic Trading’.⁶

The trading systems in ST require large amounts of capital (at least £100,000; around $130,000). The Starter System in LT needs just £1,100 or $1,500.

ST is written for relatively advanced traders with some prior knowledge of certain financial concepts. LT is suitable for novices.

ST is a generic book which doesn’t go into much detail about individual markets. LT explains how to trade specific leveraged products.

ST explains the various components of a complex trading system one by one; it isn’t until the book is finished that you can see the entire picture. In LT, I introduce a simple system in its entirety which you can start using right away. I then go on to explain how, and why, you could make it more complicated.

ST explains how to design trading systems from scratch, which requires using software to simulate historical system performance (a process called back-testing). In LT, I present a system I have already back-tested. I then explain how you can modify the system for different types of trading, and to cover different markets, without needing any further testing.

Because I have designed the trading systems in this book with the same principles in mind there are some ideas that readers of ST will find familiar, although there is no duplicated content in this book. I would recommend that you read Leveraged Trading (LT) if:

You tried to read ST and didn’t get it.

You read and understood ST, but are struggling to build a simple system from scratch.

You have not read ST and are an inexperienced trader who is unfamiliar with financial theory and back-testing software.

You are specifically interested in trading leveraged products: FX, CFD, margin accounts, spread bets and futures.

You do not have enough cash to trade the systems in ST.

You are interested in combining your own trading intuition with a trading system: Semi-Automatic Trading.

Of course, if you find this book useful, are interested in purely systematic trading, and want to develop your own trading system further, then I’d definitely recommend making Systematic Trading your next purchase.

What’s coming

This is a four-part book. Part one introduces each of the leveraged products we are going to use and explains how to make decisions about your trading setup.

Then in part two I introduce the Starter System. The Starter System is a very simple trading system which trades a single instrument, using just one kind of trading rule to decide when to open new positions.

Part three then explains how to extend the Starter System by diversifying into multiple instruments, and by adding new trading rules.

In part four I introduce some more advanced improvements that you can make to the Starter System. The final chapter of part four explains how you can continue your trading journey, either by progressing into designing your own trading systems, or becoming a discretionary trader who makes subjective forecasts about market movements whilst still using a system to manage risk: Semi-Automatic Trading.

At the end of the book there is a glossary and three appendices. Appendix A lists some useful books and websites; appendix B discusses the calculation of trading costs, and some techniques for reducing them. Finally, appendix C explains how to perform various other calculations required to run a trading system.

There are also many useful resources on the website for this book:

systematicmoney.org/leveraged-trading

These include spreadsheets that you can use to help implement all the trading systems in this book.

¹ If you aren’t familiar with some or all of these products, don’t panic. I explain them later in the book.

² A hedge fund is a type of investment fund where leverage is usually used.

³ A stop loss closes your trade when the price reaches a predetermined point. I explain stop losses in more detail later in the book.

⁴ I don’t cover options or binary options. These are fundamentally different products, and I would need to write at least one more book to explain them properly. I would advise beginner traders to avoid options. I would advise absolutely everyone to avoid binary options, which are incredibly expensive and dangerous.

⁵ You will probably have heard the term ‘Forex’ used to describe foreign exchange trading, often pronounced ‘Four-Ex’ (which makes it sound like an Australian beer). I prefer the acronym ‘FX’, pronounced ‘Eff-Ex’, which is used by professional traders. It’s also quicker to type.

⁶ I also discussed the idea of Semi-Automatic Trading in Systematic Trading, but there is much more detail in this book.

Introduction

Anyone who is contemplating risking some, or all, of their bank balance in trading needs to be aware of one important fact:

The majority of traders lose money.

There is plenty of evidence to support this depressing statistic.⁷ For example, a US study in 1999 found that only 12% of traders were consistently profitable, whilst another in 2003 found that around two-thirds of day traders lost money. Before 2010, US brokerage firms did not have to report on customer profitability. You can see why they wanted to keep these figures under wraps; an analysis of this data in 2011 showed that only 25% of their customers were in profit.

Traders in other countries are just as unsuccessful as those in the US. French financial regulators found that 89% of customers trading foreign exchange and CFDs lost money. Meanwhile the Polish regulatory body estimated that 80% of traders were losers. In Taiwan, researchers calculated that only 13% of accounts were profitable in any given year, and only 2% were able to outperform the market consistently.

What about the UK? One of the quotes at the start of this book is from a UK broker: 81% of retail investor accounts lose money.... This figure is typical in the UK FX, spread betting and CFD industry.

The mistakes that losing traders make

Perhaps the stark statistics above don’t faze you. You firmly believe that you will be in the minority of successful traders, due to your superior skill, high IQ or work ethic. I’m afraid I have to debunk your illusion. You will mostly be competing with traders with equal or superior levels of ability, intelligence and commitment. And, in any case, there is no guarantee that being a better, smarter or harder working trader will automatically lead to profitability.

So how can you avoid joining the ranks of money-losing traders?

Importantly, all the research I’ve quoted above is based on studies of amateur traders, not professionals. Nowadays I only trade my own money, but in the past I have worked as a trader for an investment bank, and as a portfolio manager for a hedge fund managing billions of dollars. In my experience, professional traders don’t make the same mistakes as amateur traders.⁸ Amateur traders should learn from the professionals and avoid three key errors:

Overconfidence: overestimating how successful you will be at trading.

Over-betting: taking on too much risk.

Overtrading: trading too frequently.

Let’s look at these in turn.

1. Overconfidence

It is very easy to become a trader. You just need a computer or smartphone, and some money (and with leveraged trading you hardly need any money at all). If it is very easy to become a trader, then surely it is very easy to become a successful trader? It is not. The markets are very hard to predict and even the best traders can’t predict them perfectly (or even well).

Do not listen to the trading gurus who tell you that returns of 50%, 100%, 200% or more each year are possible if you buy their exclusive system or sign up to their virtual private trading room. Some professional trading funds, usually labelled with the moniker ‘top hedge fund’, will have the occasional stellar year: that’s just the way luck works. But over longer time periods, where their performance is more likely to be skill than luck, even the best hedge funds make relatively modest average returns of about 15% a year.

Small retail traders do have some advantages over large funds, but these are massively outweighed by other factors. These funds trade dozens or hundreds of financial instruments, employ many highly-qualified experts, and invest millions of dollars in technology. Do you really think you can do significantly better?

Whether you’re new to trading in the financial markets, or you consider yourself an expert, it’s important that you have realistic expectations of what is possible.

Overconfidence is problematic enough, but it also encourages traders to make two other types of error: over-betting and overtrading.

2. Over-betting

It is more fun to trade with the hope of making big bucks from a small stake, than to earn pedestrian returns barely better than you could get from a bank account.

For this reason, people are drawn to the very riskiest kinds of trading – like penny stocks or obscure cryptocurrencies that can go up 100% or more in a few days. Massive risk means you have a chance of a massive reward, but it also introduces the possibility of massive losses. The trader who loses 20% in a bad year has to make 25% before they are even. But a trader who loses 90% of their capital faces the near impossible task of increasing their account ten-fold to get back to square one.

Most amateur traders take too much risk and this is why most of them lose money.

3. Overtrading

Brokers constantly encourage their customers to trade more often. They provide fancy trading apps and pretty websites with nice charts. Many brokers have relationships with celebrity trading gurus who claim to be offering an educational service. Their real business is encouraging novices to trade more, so they can collect a cut of the brokerage commission which is generated.

Whilst writing this chapter I examined the accounts of a large UK CFD and spread betting provider. They made an average of $1,379 in revenue per customer. Revenue for a brokerage company is a cost for their customers. The customers had an average of $500 on deposit with the brokers at the end of the year. Running a brokerage firm is clearly more lucrative than being a client. According to an old story, a naive client visiting New York and admiring the boats of bankers and brokers asked:

Where are the customers’ yachts?

Every time you trade you remove some money from your account and hand it to your broker.

Limit your trading to the absolute minimum. Do not assume you will make sufficient profits to cover costs which are inflated by overtrading.

Those are the mistakes that traders often make. Leverage will just make things worse. Let’s see why.

Why leverage is dangerous

Leverage magnifies the three mistakes that retail traders typically make:

Overconfidence: If you overestimate your ability to predict the markets, you’re likely to use more leverage. If you can easily make 10% a year, then why not use ten times more leverage and make 100% a year? But leverage magnifies your mistakes as well as your profits. If you’re not as good as you thought, or if you get unlucky, then you’ll lose a lot of money very quickly.

Over-betting: It’s risky to trade Bitcoin, the cryptocurrency whose value collapsed by half in a little over two weeks at the beginning of 2018. But trading Bitcoin with added leverage is terrifyingly dangerous. Even relatively pedestrian assets like US government bonds can become risky if you use the maximum leverage allowed by many brokers.

Overtrading: Leverage also increases your trading costs, so if you are overtrading your account you will be more severely punished. Suppose you have $1,000 and decide to buy gold. You pay $10 in costs for a $1,000 trade. Using leverage from a particularly generous broker you could buy 50 times more gold: $50,000. This will incur 50 times more in costs: $500. Your trading costs as a proportion of your account value have gone up fiftyfold: from 1% ($10 ÷ $1000) to 50% ($500 ÷ $1,000). You have burned up half your account just paying costs.

Easy access for amateur investors to huge amounts of leverage is superficially attractive, but incredibly dangerous if used recklessly.

Why you should use a system when you start trading

A trading system can help you avoid the fundamental errors made by most amateur traders: overconfidence, over-betting and overtrading. The systems I show you in this book are all carefully calibrated to use the correct amount of leverage, and with a trading frequency that’s crafted to suit the products you’re likely to be trading. They are based on realistic expectations of typical future performance, rather than wildly optimistic predictions.⁹

When you are an experienced trader you will want to start making changes to these systems, or even start making your own calls on the market. I explain in the final chapter how you can do this, whilst still ensuring you’re safe from repeating the typical mistakes of amateur traders.

How is this book different from other trading books?

There are thousands of books on trading listed on amazon.com. Most of them will make promises about the untold wealth you can have if you’ll just follow the author’s advice. The writers appear to know what they are talking about: you can find many of them posing on Instagram or other social media in their palatial homes or private jets, surrounded by attractive people, and waving large wads of dollar bills.

Sadly, most of these images are a facade. Most celebrity ‘traders’ don’t make huge fortunes from trading, although some make a good living from selling trading courses and books, and from kickbacks paid by brokers when they introduce new customers. The houses, jets and attractive people are usually rented for the day. You can buy a briefcase worth of fake money on eBay for a fraction of its face value. Truly successful traders usually keep very low profiles.

I take a different approach. Here is what someone wrote when reviewing my first book:

It’s not often you come across a trading book that promises you nothing in terms of riches, trading from a hammock on a beach with your laptop or becoming a billionaire hedge fund yet delivers you most of the successful components to give you a trading edge over many other market participants.

Review of Systematic Trading, on amazon.com

Just as in Systematic Trading, there is no secret recipe in this book that will allow you to make easy money in the market. I offer no guarantee of profits and you should not expect to make huge returns. Instead I offer a more realistic promise: if you follow my advice you will avoid making the errors that nearly every amateur trader makes.

Not everyone agrees with this approach. Here is a less complimentary book review:

I agree that the general principles set forth here are valid and useful. This work is marred, however, by an exceedingly pessimistic view of the kind of Sharpe ratios a skillful system developer can achieve...

Review of Systematic Trading, on amazon.com

(The Sharpe ratio, as you will discover later, is a measure of the profitability of a trading system.)

I respectfully disagree. Some people can indeed make very good money from trading. However, much of that is down to luck rather than skill, and few people will trade for long enough to know the difference. It is safer to be pessimistic: assume you don’t possess special trading skills and that you may well be unlucky.

Consider a trader who is overly optimistic and trades accordingly, using too much leverage and trading too frequently. If they have been overconfident about their abilities, or if they are just unlucky, they’ll end up with huge losses.

In contrast, a trader who is pessimistic about their likely performance will limit their trading and won’t use too much leverage. If things turn out even worse than expected, then at least they will have limited their likely losses. However, if things go well they will be pleasantly surprised. They should bank the unexpected gain with cool detachment. The trader will not dwell on the missed opportunity of additional profits if they’d only taken more risk or traded more often.

So, this is not a book for fantasists. It’s for realists who think that avoiding mistakes is paramount: controlling your risks and trading costs.

⁷ Sources: ‘Report of the Day Trading Project Group’, North American Securities Administrators Association (1999), www.nasaa.org/wp-content/uploads/2011/08/NASAA_Day_Trading_Report.pdf; Douglas J. Jordan and J. David Diltz, ‘The profitability of day traders’, Financial Analysts Journal (2003); www.financemagnates.com; ‘Study of investment performance of individuals trading in CFDs and forex in France’ Autorité des marchés financiers 2014; KNF report on trading in the over-the-counter markets, quoted in www.financemagnates.com/forex/brokers/knf-survey-polish-forex-market-shows-roulette-table-concept-80-lose-money; Brad Barber, Yi-Tsung Lee, Yu-Jane Lian, Terrance Odean, ‘The cross-section of speculator skill: Evidence from day trading’, Journal of Financial Markets (2014).

⁸ Maybe that should be: most professional traders don’t make the same mistakes as amateurs. Hubris can affect even highly intelligent professionals and the very smartest traders are most at risk of believing themselves to be invincible. Take the hedge fund Long Term Capital Management (LTCM). LTCM employed star traders who’d worked at Salomon Brothers and several brilliant professors, including two Nobel Prize winners. They ran strategies with vast amounts of leverage and for a few years were incredibly profitable. Then, in September 1998, it all went horribly wrong, and the fund lost 90% of its capital within a matter of weeks. Nearly $5bn evaporated into thin air. There are plenty of other famous examples of professionals